President Rouhani Oversaw Fragile Recovery

TEHRAN—Plummeting oil prices and the failure so far to conclude a nuclear agreement are dealing a double blow to Iran’s economy just as it was starting to recover.

Oil prices, which have fallen about 50% since June, resumed their decline on Monday after Saudi Arabia, the world’s largest crude exporter, said it may boost production despite a global glut. The slide in prices is strangling revenues in Iran, a country dependent on oil money.

Compounding the problem, Iran and six world powers also missed a deadline in November to conclude a comprehensive deal on limiting Iran’s nuclear activities, something that has dimmed hopes for crippling economic sanctions to be lifted anytime soon.

The renewed economic travails are eroding gains that accompanied President
Hasan Rouhani’s
surprise election 18 months ago. Mr. Rouhani, whose political fortunes rest largely on an economic recovery, has been scrambling to contain the damage. In a recent address to parliament, he touted a radical but difficult plan to address what he called an unprecedented oil slump: cutting dependence on oil income by boosting industrial exports and hiking taxes.

He has also proposed dramatic fiscal tightening in the new Iranian year that begins in March.

“Iran is moving to a very austere budget,” said
Fereydoun Khavand,
an Iran expert and senior lecturer at Paris Descartes University.

Iran’s economic progress came after significant reforms, bolstered by a leap in optimism that the president would be able to get international sanctions over Iran’s nuclear program lifted through an agreement with the West.

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Inflation had stopped accelerating over the past year, falling to about 20% on an annual basis currently compared with 35% in recent months, according to the government.

The rial lost two thirds of its value against the dollar in 2012 as banking sanctions tightened. It has regained some ground since then, but lost 5% in a week against the dollar when the deadline for reaching a nuclear deal was extended beyond November.

President Rouhani continues to focus on nuclear talks. He advocated for a deal again in remarks carried by Iranian state media in recent days, directly challenging hard-liners who oppose any agreement with the West. Such an agreement would bring access to oil funds blocked abroad and foreign investment that “would largely make up for the oil slump,” Mr. Khavand said.

“This is a mistake to imagine that by oil they can change the strategic major issues in the region,” Iranian Parliament Speaker
Ali Larijani
said Sunday during a visit to the Syrian capital Damascus, where he pledged closer ties to President
Bashar al-Assad’s
regime. “We Iranians have experienced much harder situations than this.”

Iran’s financial support for Mr. Assad in the Syrian civil war is adding to the headwinds, said
Karim Sadjadpour,
an analyst with the Carnegie Endowment.

“Syria is costing billions of dollars, the drop in oil prices tens of billions and the (35 years of) sanctions, hundreds of billions,” he said.

It is expensive to provide the Syrian regime credit lines on oil and other goods along with military aid. But Iran sees the battle in Syria as one of its highest overseas priorities and “can justify the cost of sticking with Assad,” said
Emile Hokayem,
an analyst with the International Institute for Strategic Studies.

Combined with the cost of Iran’s foreign policy, the new economic hardships pose formidable challenges for Mr. Rouhani and the optimistic turn in sentiment his presidency ushered in. Sanctions relief agreed with the West a year ago has unlocked $4.2 billion of oil funds and eased oil sales and food imports.

Thanks to a detente with the U.S. and tighter monetary policies, the economy had reversed a two-year recession and returned to a projected growth track of about 1.5 % in the fiscal year ending March 2015, according to the International Monetary Fund. Inflation had started to plateau.

“During the last government, we have faced a lot of difficulties as a result of sanctions,” said Shahram, a perfume and cosmetics seller at Tehran’s bazaar who only gave his first name. “Since President Rouhani was elected, we can’t say everything has changed for the better. At least, prices have stabilized.”

The government’s recently released budget plan for next year assumes oil prices will average $72 per barrel, more than one-quarter below the average price of $100 per barrel assumed in this year’s budget. But, according to the IMF, the Islamic Republic needs close to $131 a barrel to cover government spending this year and next.

To try to avoid a fiscal shortfall, Iran plans to cut the share of oil revenue it sets aside for a separate infrastructure budget to 20% from 31%, according to government officials.

Parliament has also voted to raise taxes, possibly even on currently tax-exempt religious foundations and military-linked companies, though Supreme Leader Ayatollah
Ali Khamenei
would need to sign off on such a radical change. Iran’s massive religious foundations operate like corporate conglomerates outside the country’s regular laws, while a Byzantine web of companies tied to the powerful Iranian Revolutionary Guards have won billions of dollars of oil contracts after Western giants pulled out.

Meanwhile, the Rouhani government hopes to take advantage of the drop in global energy prices to reduce government subsidies on fuel and food.

To avoid hurting low income earners and industrial companies, additional revenue will come from direct taxes on wealthier families, said Hamidreza Fouladgar, a member of Iran’s parliamentary commission on industries. For the first time, a previously ignored consumer tax has appeared on restaurant bills, Tehran residents say.

In his administration’s budget presentation, Mr. Rouhani also proposed cutting reliance on oil revenue, which finances 50% of the current budget to 33% and compensating with non-oil exports.

The latter—which include cheap Iranian-made vehicles sold to Iraq and Afghanistan and natural gas-based petrochemicals shipped to China—have risen by 20% in the past eight months, according to Iran’s customs administration. Still, sectors that had been considered as havens against the economic pain inflicted by sanctions are also being hit.

The Tehran Stock Exchange has fallen sharply by 8% since the extension of nuclear talks was announced as investors have adjusted their expectations.

So has what was a surprisingly bubbly real-estate market, according to industry sources. One real-estate investor said current transactions on Tehran’s property market suggested a drop of 35% compared with two years ago.

“The real estate bubble is bursting because of political uncertainty,” he said. By contrast, the rental market is booming, he added, a sign people are holding on to cash instead of investing it.

Gold, another hedge against risk for many Iranians, has also gained value, said a 53-year-old trader of the commodity near Tehran’s bazaar. When the extension of the nuclear talks was announced on Nov. 24, the price of a coin rose by 4% in two days, he said.

While taking a huge toll on the economy, the Western-led sanctions regime has also provided something of a buffer against the drop in oil prices. Among top hydrocarbons producers, Iran is one of the least dependent on oil revenue. They account for 22% of its gross domestic product compared with about 46% for Iraq and Saudi Arabia, according to the World Bank.

The economy has been forced to further diversify away from oil revenues, and only a trickle of actual funds from overseas sales makes it through the international banking system and into government coffers where it can be spent.

“Lower oil prices simply magnify the effect of the sanctions,” said
Mostafa Pakzad,
Chairman at Pakzad Consulting Corp., which advises foreign companies trading in Iran. But all the same, “there are buffers because Iran has been under sanctions for so long.”

In his address to parliament, Mr. Rouhani said the proposed budget expands revenues beyond oil sales to an “unprecedented” extent and represents an “opportunity to separate the budget from dependence on oil revenues.”

Because of banking restrictions, more than $100 billion in oil revenue is blocked abroad,
Rahim Zareh,
the spokesman for the economic commission in Iran’s parliament, told The Wall Street Journal.

“The direction we are taking is to stop relying on oil anymore and to use it as savings for investment,” he added.